Example: Three-factor Analysis

Company A and B operate in the same market and are of the same size. Both earn a return of 15% on equity. The following table shows their respective net profit margin, asset turnover and financial leverage.

Company A

Company B

Net Profit Margin

10%

10%

Asset Turnover

1

1.5

Financial Leverage

1.5

1

Although both the companies have a return on equity of 15% their underlying strengths and weaknesses are quite opposite. Company B is better than company A in using its assets to generate revenues but it is unable to capitalize this advantage into higher return on equity due to its lower financial leverage. Company A can improve by using its total assets more effectively in generating sales and company B can improve by raising some debt.